Tax Policy Alert
On October 4, 2007, the Senate Finance Committee approved a proposal that would codify the economic substance doctrine. The Committee approved the proposal in the context of a markup of the Heartland, Habitat, Harvest and Horticulture Act of 2007. The proposal would codify the economic substance doctrine based on a conjunctive test requiring both a meaningful change in economic position and a business purpose, and would apply a strict liability penalty of 30% (20% if disclosed) to understatements attributable to transactions lacking economic substance. Given the significant revenue raised by this proposal ($10 billion over 10 years), it is anticipated that the proposal will be given serious consideration as the Congress addresses a lengthy and costly tax agenda this fall.
Background - The Economic Substance Doctrine and Recent Codification Efforts
The economic substance doctrine is a longstanding judicial anti-abuse doctrine used to deny tax benefits associated with tax-motivated transactions under certain circumstances. Despite objections from the Treasury Department and the Internal Revenue Service (the “IRS”), in recent years the Senate has on multiple occasions passed legislation that would codify the economic substance doctrine and apply a significant strict liability penalty to those transactions that failed to satisfy the requirements of the doctrine. Specifically, the pre-2007 proposal passed by the Senate provided that a transaction had economic substance only if (1) the transaction changed in a meaningful way (apart from Federal tax effects) the taxpayer’s economic position, and (2) the taxpayer had a substantial non-tax purpose for entering into such a transaction and the transaction was a “reasonable means” of accomplishing such purpose. Transactions that failed to satisfy these requirements were subject to a 40% strict liability penalty (reduced to 20% if the transaction was disclosed). House Republicans routinely rejected the Senate’s pre-2007 attempts to codify the economic substance doctrine.
The Revised Proposal
While the proposal approved by the Senate Finance Committee on October 4th (the “New Senate Proposal”) would codify the conjunctive economic substance test and apply strict liability penalties to understatements from transactions lacking economic substance, it contains significant modifications to the proposal that has previously been passed by the Senate (the “Prior Senate Proposal”). Like the Prior Senate Proposal, the New Senate Proposal would deny a deduction for interest from any understatements from transactions lacking economic substance and would be applicable to transactions entered into after the date of enactment. A number of the most significant changes contained in the explanation are discussed below.
State and Foreign Tax Planning
As noted above, under the Prior Senate Proposal, the economic substance doctrine required that a transaction (1) result in a meaningful change (apart from Federal tax effects) in the taxpayer’s economic position, and (2) have a substantial non-tax purpose (subject to the “reasonable means” test described below). As a result, although state and foreign tax benefits were considered in determining whether there was a meaningful change in a taxpayer’s economic position, arguably such benefits were not considered in determining whether a transaction had a substantial purpose because the statute required a “non-tax” rather than a “non-Federal tax” purpose. The New Senate Proposal, however, specifies that a transaction must have a substantial “non-Federal tax” purpose, such that state and foreign tax benefits are considered unless such benefits are (1) due to similarities between Federal law and state or foreign law, and (2) less than or coextensive with the Federal tax benefit claimed.
Elimination of the “Reasonable Means” Test
The Prior Senate Proposal required that a transaction be a “reasonable means of accomplishing” its substantial non-tax purpose. Taxpayers expressed concern that such a “reasonable means” test could effectively be used by the IRS to substitute its business judgment for that of taxpayers in determining the means by which a transaction was completed. The New Senate Proposal eliminates the “reasonable means” test.
Taxpayers expressed concern that the scope of the Prior Senate Proposal was so broad that common, non-controversial transactions that otherwise satisfied the requirements of the Internal Revenue Code (the “Code”) could improperly be subject to the codified economic substance test. The New Senate Proposal attempts to limit the scope of the codified economic substance test by providing that if tax benefits are “clearly consistent” with all applicable Code provisions and the purposes of such provisions, such benefits will not be disallowed solely on the basis that the underlying transaction fails the codified economic substance test. The New Senate Proposal further provides that the tax treatment of certain basic business transactions is not altered as a result of the codification of the economic substance doctrine. These basic business decisions include (1) the choice between capitalizing a business with debt or equity, (2) the choice between foreign and domestic corporations, (3) the treatment of corporate organizations and reorganizations, and (4) the ability to recognize a related party transaction that satisfies the arm’s length standard of section 482. Finally, the New Senate Proposal also provides the Treasury Department with a grant of regulatory authority to exempt classes of transactions from the application of the provision.
Changes to Profit Potential Test
Under the Prior Senate Proposal, a taxpayer using profit potential to demonstrate that a transaction resulted in a meaningful change in the taxpayer’s economic position was required to meet a minimum threshold. Specifically, a taxpayer was required to show that the profit potential exceeded a risk-free rate of return. For purposes of determining pre-tax profit, fees, transaction expenses and foreign taxes were treated as expenses.
Under the New Senate Proposal, there is no minimum threshold specified to satisfy the profit potential test (i.e., the requirement that the profit potential exceed the risk-free rate of return has been eliminated), although the proposal retains a requirement from the Prior Senate Proposal that the anticipated profits must be substantial in relation to the Federal tax benefits claimed. Furthermore, for purposes of the profit potential test, the treatment of foreign taxes as expenses is left to the discretion of the Treasury Department through a grant of regulatory authority.
Elimination of Special Rules of Lessors and Transactions with Tax-Indifferent Parties
The Prior Senate Proposal provided special rules for (1) lessors using the profit potential test, and (2) certain transactions involving tax-indifferent parties. The New Senate Proposal eliminates these special rules.
Strict Liability Penalty
The Prior Senate Proposal provided that any understatement that was attributable to a transaction lacking economic substance was subject to a 40% strict liability penalty (reduced to 20% if the transaction was disclosed). Furthermore, the penalty also applied to transactions that were disregarded under “any similar rule of law,” such as the sham transaction doctrine. The New Senate Proposal decreases the amount of the strict liability penalty from 40% to 30%, but retains the 20% penalty for disclosed transactions. In addition, the New Senate Proposal limits the application of the strict liability penalty to those transactions lacking economic substance (i.e., it does not apply to transactions that are disregarded under “any similar rule of law”).
Administration of the Strict Liability Penalty
Under the Prior Senate Proposal, the strict liability penalty could be asserted by the IRS examination team without National Office approval. Furthermore, once the penalty was asserted, it could only be waived personally by the Commissioner (i.e., the power to compromise the penalty for purposes of settlement could not be delegated). The New Senate Proposal provides that the strict liability penalty cannot be asserted until it has been reviewed and approved by the IRS Chief Counsel (or, if delegated, a branch chief). Furthermore the taxpayer is allowed to submit a written statement in connection with such review by IRS Chief Counsel. The New Senate Proposal also provides that the penalty can be waived by the IRS Chief Counsel (or, if delegated, a branch chief).
Although at the margins the New Senate Proposal reflects significant and liberalizing changes from the Prior Senate Proposal, it nevertheless maintains the fundamental elements of the prior proposal: the codification of the two-part conjunctive test and the application of an onerous strict liability penalty regime. It is unlikely that the changes will win support for the proposal by the Treasury Department, the IRS, or the taxpayer community. If the New Senate Proposal is enacted, the Treasury Department and the Internal Revenue Service will face significant issues in deciding how to implement and administer the new rules, in particular in light of the significant grants of regulatory authority. Furthermore, taxpayers will need to consider the impact that enactment of the New Senate Proposal will have on their tax planning and their audit relationship with the IRS.
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Lawrence Gibbs, email@example.com, 202-626-6005
Rocco Femia, firstname.lastname@example.org, 202-626-5823
Marc Gerson, email@example.com, 202-626-1475